Why America’s fear of ‘too big to fail’ is irrational

March 31, 2014, 10:23 PM UTC
Fortune

The reality is U.S. companies across all industries may be ‘too big to fail,’ not just Wall Street banks.

The domino effect of ‘too big to fail’

FORTUNE — The U.S. Federal Reserve recently concluded that six of America’s biggest banks enjoy about $8.5 billion a year in savings, mostly in the form of paying lower borrowing costs than smaller institutions. That might sound unfair, but that’s a pretty small price U.S. taxpayers effectively pay to avoid another financial crisis. In addition, the Troubled Asset Relief Program, though unpopular, actually netted a profit for taxpayers as the government’s investments have been gradually wound down; and then there is the case of Ally, the former General Motors (GM) finance subsidiary, whose planned IPO will result in a gain for the public.

Still, the fear of “too big to fail” persists. The reason for this is a lack of understanding of why our biggest banks can’t really be allowed to fail.

“Too big to fail” doesn’t exist because we have sympathy for Citigroup (C) or JPMorgan Chase (JPM) or because Wall Street is too powerful. It exists to preserve the integrity of the global financial system, which is a complex and interconnected web of financial relationships that cannot realistically be insulated from the downfall of even a single large bank.

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 Consider one scenario: Bank A is a large financial institution that lends to businesses of all sizes. Firm B is a medium-sized manufacturer of components for mobile phones sold by electronics giants and depends on Bank A for funding its inventory. If Bank A collapses and stops lending, Firm B would be unable to pay its suppliers and provide electronic parts to phone makers.

If the impact is severe enough, this can put the firm, its vendors, buyers (and their buyers like wholesalers and retailers) out of business or at least under great financial pressure. That, in turn, would cause these companies to default on debt from other banks, destroy value for shareholders, and force them to fire workers. This would also cause a reduction in consumer spending because of the resulting unemployment and investor losses, thereby hurting consumer businesses as well.

This cycle of falling dominos, once it begins, is unstoppable and can bring down the entire economic system. After the crisis of 2008, it should be obvious how fragile and interdependent the global economy really is. That is the new normal, and it is not likely to change.

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Which leads us to accept the reality of “too big to fail.” Distasteful as the concept might be to taxpayers, it is ultimately the lesser of two evils: a bailout or financial catastrophe.

 Also, banks aren’t the only entities that are too big to fail. Amazon (AMZN), Google (GOOG), Exxon Mobil (XOM), Wal-Mart (WMT), and Pfizer(PFE), for instance, are all major employers, buyers, suppliers, and business partners. If any of them were to fail, it would certainly have a spillover effect on other companies, banks, and individuals. Given their $100-billion-plus market capitalizations, their collapse would send a nasty shockwave through the global economy. Even though they fall across different industries, their scale can be considered too big to fail because their collapse would be disastrous for the economy as a whole.

This does not mean that “too big to fail” is something to be celebrated or that banks should not be required to manage their risks better, but even with tighter regulations like the Volcker Rule in place and stronger oversight from governments, this phenomenon is not going away — if for no other reason than that corporate consolidation can be highly profitable and enhance marketing power. The best we can do (for now) is to understand the dynamics of “too big to fail” better, be vigilant market watchers and investors, and look for ways to mitigate the risk.

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein, as well as at hedge fund Ramius. Sanghoee sits on the board of Davidson Media Group, a mid-market radio station operator. He has an MBA from Columbia Business School and is also the author of two thriller novels. Follow him @sanghoee.